That’s according to the founder and CEO of automated investment service, Stockspot. Chris Brycki said the main danger that comes with borrowing to invest is “obvious” and that a poor investment return can amplify any losses made.
Further, it could even lead to a situation in which more money is owed than is actually owned.
“Leverage can work in both directions,” Mr Brycki explained. “Over the short run, investment can go up or down by significant amounts so when borrowing you need to be comfortable investing for a long time. Otherwise your chances of making a large loss or completely wiping out your savings are high.
“Borrowing to invest as a way of amplifying short-term returns is usually a bad idea because markets (share markets and property markets) are very unpredictable,” he said, highlighting the five elements to consider before borrowing.
1. Time horizon
Mr Brycki said investors need to ask themselves if their investment horizon is at least five to 10 years.
He explained: “It’s important to remember that past performance is not a good indicator of future returns, and there’s always risk associated with investing in any asset class.”
Keeping an eye on long-term perspective is “vital” because the best performing investment in one year could become the worst performing in the next year.
“If you’re intent on borrowing to invest, more than anything make sure your time frame is long enough to withstand market falls and that you’re not going to be a ‘forced seller’ in that situation,” he advised.
2. Reliable income
The second question for potential borrowers is whether they have a plan B, or “rainy day fund”.
He said investors need to consider how they would pay the interest on the loan should they lose their job.
3. Extra savings
“If you’re borrowing to invest in shares, you may get a ‘margin call’ if those investments fall in value,” he warned.
In this event, investors would need to supply more capital so that the overall gearing doesn’t exceed a certain level.
A high marginal tax rate means investors can benefit by claiming the difference between the income derived from the investment and the interest off the income, Mr Brycki noted. But this doesn’t mean it’s necessarily the best option, he added.
“It may not be the right decision to invest in negatively geared investments since interest will put you behind and you rely on the value of the investment increasing,” he explained.
Investors need to consider whether they have the “staying power to stick with the plan” and remain invested, even if the market falls 30 per cent within a year.
He advised that if a fall of that severity is “going to make you lose sleep at night”, then leveraging investments is “not for you, or you should consider borrowing less”.
Behavioural economist and 2017 Nobel Prize winner Richard H Thaler identified the compulsion to intervene as a critical human cognitive bias which can see humans forget the way they misunderstand causality and their own competence. As such, solutions may be put in place which can lead to failure".
Even if investors satisfy these five requirements, Mr Brycki said borrowing may not still be the best path, especially if the extra risk isn’t actually required to achieve their goals.
Quoting Warren Buffett, Mr Brycki said that as long as investors are smart, they can make “a lot of money without borrowing”.